Bursting Bubbles Mean Inflation to Give Way to Deflation

Widespread is the notion that inflation is back for good. Many assume that the relative price stability of the past two decades has been irrevocably shattered by “peak oil” and the surging demand by developing economies. Improvement of living standards in those developing countries has caused, and will continue to cause, increasing demand for calories, and final demand for food will outstrip supply. Additionally, the cost of basic materials is lifting production costs, and the cycle of higher food and fuel costs means that the prices of all imported goods to the United States will continue to rise. The fixed income investment conclusion is that inflation is endemic, and since the market does not currently reflect such dire inflation prospects, long dated Treasury securities should be sold. We would be among the first to move to the short dated part of the curve if the economic statistics supported the above view. Our conclusion is that deflation, not inflation, is, and will continue to be, the essential problem for the U.S. economy and that the optimum fixed income portfolio should consist of treasuries with the longest possible maturities.


Twelve months ago the annual increase in the CPI was 2.6%. Today it is at 4.1% and rising. The Reuters/Jefferies CRB Index fell 7.3% for the year ending last June. Today the 12 month change is 36% higher. Nevertheless, the 30 year bond yield fell to 4.5% on June 30 of this year, well down from 5.1% one year ago. This provided a remarkable 15% return for investors. How is it possible that bonds, which have the ultimate sensitivity to inflation, would decline in yield and rise in price in such an inflationary environment? The short answer is that in the broadest terms, insufficiency of demand has, and will continue, to overwhelm inflationary forces, creating deflation in many categories.

In the second quarter, current dollar gross domestic product totaled an estimated $14.3 trillion, about $572 billion greater than a year ago. Of this gain, $359 billion can be attributed to price increases and $213 to higher real output. There are times, however, when GDP is not the final arbiter of the economy’s performance, and this is one. The seemingly large gain in GDP pales in comparison to the loss in wealth, which GDP does not capture. Over the past fiscal year, holdings in the stock market, as measured by the Wilshire 5000 Stock Index, lost more than $2.1 trillion. Simultaneously, the 15.3% contraction in the Case Shiller Home Price Index suggests the wealth loss in value of household residences was a staggering $3.1 trillion. Without including the negative wealth impact for declining prices of automobiles and other durables the total wealth loss was approximately $5.2 trillion. Obviously, the sum of dollars being erased from our economic system has overwhelmed the amount of dollars being increased by inflation by a factor of more than 14 to one. Thus, once again, the bond market had it right–deflation is in ascendancy. Treasury bond yields fell, and they will continue to trend lower, creating an even more profitable environment over the next four quarters for long-term Treasury bond holders.

Market Oracle